Monday, November 16, 2015

Fiduciary Duties Conform to the Level of Protection Required

It is time for financial planners and investment advisers to become part of a true profession.

There are many different
types of fiduciary relationships. The duty of loyalty itself, and the ability to waive the fiduciary standard, is adjusted to fit the varied types of relationships. In some fiduciary relationships, less protection is required; in others, a much stronger degree of protection required. Generally, the greater the disparity in knowledge and skill between the fiduciary and the entrusted (agent, or business partner, or client), the more strictly the fiduciary standard of loyalty is applied.

Employer-employee relationships.For example, suppose you are
an employer, and your employee acts as your agent to purchase some goods for
you. The employee has a fiduciary duty to you. Under the best interests
fiduciary standard applicable to principal-agent relationships, any conflicts
of interest which exist or which may arise must be disclosed by the employee,
and the employer must provide consent. For example, if the employee earns a
commission upon the purchase of goods, the employer may consent to the
employee’s receipt of that commission. In essence, the employer may waive this
non-adherence to the fiduciary duty of loyalty that the employee possesses. Of
course, in this type of relationship the employer nearly always has greater
power and greater knowledge of the subject matter, than the employee. Hence, we
don’t feel a great need to protect the employer, as long as there is
affirmative disclosure of the conflict of interest and informed consent.

Business Partners.Then there are fiduciary
relationships applicable to partners, or members of a limited liability
company, with respect to each other. Most state laws permit the parties, at
least to some degree, to contract out of fiduciary duties that might otherwise
apply. In these situations the law recognizes that the partners likely possess
equivalent knowledge and fairly equal bargaining positions, at least when the
partnership or limited liability company relationship is entered into.

Attorney-Client Relationships.In contrast, look at the
fiduciary relationship between an attorney and her or his client. The law
recognizes that, in such a relationship, the attorney has vastly superior
knowledge than the client possesses of the law and how the law might be
applied. Hence, the lawyer cannot ask a client to waive compliance with a
lawyer’s duty of care, nor can the lawyer ask a client to simply waive a
conflict of interest where the lawyer is likely to secure a monetary benefit.

For example, under Rule
1.8(a) of the American Bar Association’s Model
Rules of Professional Conduct, a “lawyer shall not enter into a business
transaction with a client or knowingly acquire an ownership, possessory,
security or other pecuniary interest adverse to a client unless: (1) the
transaction and terms on which the lawyer acquires the interest are fair and
reasonable to the client and are fully disclosed and transmitted in writing in
a manner that can be reasonably understood by the client; (2) the client is
advised in writing of the desirability of seeking and is given a reasonable
opportunity to seek the advice of independent legal counsel on the transaction;
and (3) the client gives informed consent, in a writing signed by the client,
to the essential terms of the transaction and the lawyer's role in the
transaction, including whether the lawyer is representing the client in the
transaction.”

Hence, the ethics rules
governing attorneys require multiple steps when a lawyer might acquire a
pecuniary interest that is adverse to that of the client. The transaction must
remain fair and reasonable. The lawyer must advise the client that the client
should seek out independent legal counsel. And the client must provide informed
consent to the transaction.

But, it is self-evident, that
consent is not “informed” – nor is the transaction “fair and reasonable” – if
the client might be harmed. The ABA’s comment to Rule 1.8 provides this
example: “[I]f a lawyer learns that a client intends to purchase and develop
several parcels of land, the lawyer may not use that information to purchase
one of the parcels in competition with the client or to recommend that another
client make such a purchase. The Rule does not prohibit uses that do not
disadvantage the client. For example, a lawyer who learns a government agency's
interpretation of trade legislation during the representation of one client may
properly use that information to benefit other clients.

Investment Adviser - Client Relationships.So now we turn to investment
advisers. Are investment advisers more like employers, or more like partners,
or more like lawyers, in terms of the stature and abilities and knowledge of
the entrustor - employer, other partners, or client? One can only conclude that
clients of financial and investment advisers are much more like clients of
attorneys, and not at all like partners entering into a partnership agreement (who presumably have fairly equal knowledge and expertise). Clients of investment advisers certainly don't possess the superior knowledge and skill that most employers
possess with respect to their employees.

Clients of investment
advisers simply lack the knowledge of the financial markets that financial
advisors do. And clients are not likely to gain such knowledge without a very
substantial investment of time and effort, and even then many clients won’t
possess the aptitude for matters of finance.

Hence, between investment
advisers and their clients there exists this huge gap of information. This gap
is what allows the clients of a fiduciary to be taken advantage of. The
academic research in support of this is absolutely clear. We are no more likely
to turn the average consumer into a skilled consumer of investment advice,
armed with all the knowledge required to protect himself or herself, than we
are to turn the patient of a doctor into a brain surgeon.

Many Clients of "Financial Advisors" Believe Their Advisor Doesn't Get Paid - Anything! The SEC knows this. The 2008
Rand Report, commissioned by the SEC, revealed that 35% (75 of 214) clients of
professionals who were able to answer a question on fees thought that were
paying no fees to their financial advisor. Many more clients couldn’t answer
the question posed by Rand, in their survey.

I have personally seen this
lack of knowledge over and over again. I have talked to many potential clients who, upon inquiry, thought that their broker was a "good guy" who "was not charging us, because he is a friend."

Second Opinions Reveal the Harm Often Caused.A couple of years ago I did a portfolio
review for a highly educated retired engineer and executive. This person,
despite spending time reading much of the information that was provided, had no
idea that she was paying total fees and costs which approached 2.5% on a
portfolio which was well over $1.5 million. For another couple, for whom I did
a portfolio review about a year ago, the couple had no idea that the dual
registrant who was serving them was, in addition to receipt of investment
advisory fees, also getting 12b-1 fees and payments for shelf space.

I often provide second
opinions on portfolios. When I do my analysis, and reveal these fees and costs to
the clients of these “financial advisors,” these individual investors often get
very angry. Not just at brokers, but at the entire financial services system.

Disclosures Are Ineffective.It is just absolutely clear
that investment disclosures are not read. Even if read, these disclosures are
not understood. No amount of simplification of disclosures is going to fix
this. For even if high fees are revealed, many clients believe that high-cost
products are better investments. Of course, the academic research is clear that
higher-cost products, on average, directly correlate with lower returns to
investors.

In Conclusion.

There currently exists a "battle for the soul of the profession." On one side are those who desire to adhere to the old ways - trust-based selling leading to product sales. On the other side are those who recognize that the fiduciary standard is needed - both to protect our fellow Americans but also to bring the delivery of financial planning and investment advice to the level of a true profession.

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Ron A. Rhoades, JD, CFP® sailed across the Atlantic on a tall ship, performed in theme parks and road shows in Europe and America as a Disney character, rowed on a championship crew team, marched in the Macy’s Thanksgiving Day Parade, marched in competition with a state-champion rifle drill team, undertook a solo one-week trip into the Everglades, escorted numerous celebrities around Central Florida, performed as a “Tin Man” at a mountaintop theme park called “The Land of Oz” in Beech Mountain, NC, and served as a stage manager and talent scheduling coordinator for entertainment productions at Walt Disney World. And then he graduated college.

Since then, Ron Rhoades earned his Juris Doctor degree, with honors, from the University of Florida College of Law, which was preceded by a B.S.B.A. from Florida Southern College. Ron Rhoades has 30 years of experience as an attorney, with nearly all of those years substantially devoted to estate planning, tax planning, and retirement plan distribution planning. Ron also has over 15 years as a personal financial adviser. He was a principal with an investment advisory firm where he served as its Director of Research and Chair of its Investment Committee.

The author of numerous articles published in financial industry publications and several books, Dr. Rhoades has been quoted in numerous consumer and trade publications, and has been interviewed on Bloomberg's "Masters in Business" radio show segment. He writes occasional articles for industry publications. Ron is a frequent speaker at local FPA chapter meetings and national conferences in the financial planning and investment advisory professions.

Ron Rhoades was the recipient of The Tamar Frankel Fiduciary of the Year Award for 2011, from The Committee for the Fiduciary Standard, as he “altered the course of the fiduciary discussion in Washington.” He was also named as one of the Top 25 Most Influential persons associated with the investment advisory profession in 2011 by Investment Advisor magazine, and was voted to the “Sweet 16 Most Influential” in Wealth Management’s 2013 “March Madness” competition. Dr. Rhoades was also named as one of the "Top 30 Most Influential" members in NAPFA's 30-year history in 2013. This blog was also called one of the "Top 25 Most Dangerous" in financial services.

Ron A. Rhoades, JD, CFP® became Program Director for the Financial Planning Program (B.S. Finance, Financial Planning Track) at Western Kentucky University's Gordon Ford School of Business in July 2015. He provides instruction to highly motivated, exceptional undergraduates students in such courses as Applied Investments, Retirement Planning, Estate Planning, and the Personal Financial Planning Capstone course. He has previously taught courses in Insurance & Risk Management, Employee Benefits, Money & Banking, Advanced Investments, and Business Law I and II.

Ron also serves on the Steering Committee of The Committee for the Fiduciary Standard, on whose behalf he frequently travels to Washington, D.C. to meet with policy makers in Congress and in government agencies regarding the application of the fiduciary standard to personalized investment advice.